Future Trading: Hedging the Investment from Market Volatility

Future Trading | Many of the investors of our society might have not heard this word Hedging. I can bet  you that they do not have knowledge about the benefits of Hedging or if they have they must have not tried that in their actual trading practices. Sometimes people say "Hedging" is similar to the word "Speculation". But they are wrong. Hedging is good practice to save money from going in loss. In short, Hedging is a tool to save your investment from loosing it value.

So I shall take you that level of understanding where you will understand how hedging can save you and your money

So let us start the word Hedging...

What is Hedging?

Hedging refers to taking two contrary positions on an underlying asset to protect yourself from price volatility and risk.

Suppose you are a merchant who sells jewelry in the market. You have received an order to sell by the end of May. Now for selling jewelry, he has to buy gold from a dealer and make jewelry and sell it by the end of the month of May. Now suppose at the end of May, gold prices go down. In this case, the merchant will suffer loss in the inventory value if he buys gold today.

To hedge this, the merchant buys the derivative contract on commodity derivative exchange to sell the equal quantity of gold. Now suppose today the price of gold is Rs. 35,000 per 10 gm. Now you buy 2-kilo gold for Rs. 70 Lakhs and on the same day he sells a future contract for around the same sum.

Now assume if by the end of May gold price per 10 gm falls to Rs. 30,000. So were he not hedged himself, he would have incurred a loss of Rs. 5000 per 10 gm.

In the case of hedging the volatility of gold price, the loss of Rs. 5000 per 10 gm on the spot market would be compensated by a gain on the futures market ( where he sold).

Practicality of application of Hedging in real world

In practical life, hedging involves cost and only those entities who have experienced treasury can hedge themselves.

Generally, these entities hedge gold either on the over-the-counter market dominated by banks or commodity exchanges like MCX. In the recent period, NSE and BSE have also launched gold derivatives.

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